Sweeting spoke to Global Investor/ISF about his new research paper on credit and long-term investment, The Waiting Game.
High-yield bonds present several advantages for long-term investors such as pension funds, yet many are naturally concerned about volatility and credit risk.
Sweeting said that while many investors need to mark their assets to market, there is an alternative approach to investing in high-yield. While the level of income generated by investment is closely related to the level of credit risk, his research finds that credit risk is not the only reason for higher yields.
“Rather than looking at how to time the market, this paper looks at the case for investors considering whether credit asset classes make sense given their level of confidence and the time horizon they might need for de-risking their portfolios.
“A long-term investor or pension fund shouldn’t necessarily be too concerned about volatility of different asset classes, particularly in the credit spectrum. Just because spread moves in and out doesn’t mean income will be adversely affected. In 2008-2009 spreads moved out very sharply for low-rated debt and income kept tumbling in.
“For example, if you’re investing in high-yield over a 20-year horizon then providing the spread is big enough at the beginning, you’d expect to squirrel away enough in additional coupons that it doesn’t really matter what the spreads are in 20 years’ time.”
His analysis shows for what period of time investors need to hold credit assets in order to give them a “reasonable degree of confidence” that they would beat US Treasuries.
Sweeting said this can be particularly beneficial for pension funds that need to take a long-term view.
“It’s important to have a good idea of the underlying economic situation of the pension scheme rather than just mark-to-market. This approach is important for defined benefit (DB) pension schemes as many of them have deficits so need to invest more aggressively.
"Many might feel nervous about investing in high yield or emerging market debt because of the additional volatility but if you’re investing in credit for a long-term horizon, providing spreads aren’t too narrow, you have a very high probability of beating your liabilities or the US Treasury benchmark over that time, including being able to make pension payments.”
In the paper Sweeting said that by the amount needed to beat US Treasuries at shorter time periods is higher for high yield than for investment grade if the spreads are ignored. However as high-yield spreads are higher, the buffer built up leads to a fall in the amount needed to beat Treasuries.
For example, if the high-yield spread is 3.82%, there is a 75% chance that investment-grade corporate bonds would outperform Treasuries over a 15-year time horizon. The probability of outperformance rises to 90% and 95% over 18 years and 20 years respectively.